Operational Culture Shift Drives a Huge Comeback

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If your business is hurting, effective remedial tools might be in plain sight. You may just have to train yourself to see them.

ARC Document Solutions, a 25-year-old company known for most of its life as American Reprographics Co., was knocked for a loop in 2008 and 2009. Lots of companies were, but ARC derived its sustenance from a type of endeavor that arguably was crippled as much as or more than any other: mammoth construction projects, like urban multi-use developments, sports stadiums and hospitals.

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The company’s main business was printing data-intensive, very precise documents like blueprints and technical drawings for such large-scale projects. The first alarms went off in 2007 as a long, oppressive capital crisis took root, slowing down some projects. After financial markets seized up in September of 2008, nonresidential construction came to an almost complete standstill.

Compounding the misery, during that same time period a trend that had been gaining steam for a few years approached a critical-mass stage: more and more construction data was being stored and accessed online.

After turning a nice profit, as usual, in 2008, ARC, a $400 million, publicly traded company, suffered heavy bottom-line losses the next four years. In 2013 the sun finally poked through the clouds; through three quarters, the company had eked out a small profit (full-year results will be revealed in March). ARC finance chief John Toth is forecasting strong results for 2014.

The recovery was engineered through a couple of new approaches. One was thoroughly strategic. ARC, over time, shifted (and is still shifting) away from a strict focus on big construction projects.

“Our customers depend on projects, but not only projects,” says Toth, who joined the company as CFO in July 2011. “They do tenant improvements, remodeling, pitches and consulting. Previously, we focused only on the ‘big project’ part. Now we focus on the AEC [architecture, engineering, construction] enterprise and all of its activities and document needs. If 20 years ago we were a company that only printed blueprints, in five years we’re going to be an enterprise content management company.”

A rejiggered portfolio of offerings includes online data-management services, other technical services and printer software.

The other, perhaps more interesting remedial step was more tactical in nature, and had a much quicker payoff: a 260-basis-point improvement in gross profit margin from 2012 to 2013 and a tripling of ARC’s stock price in the past year.

Working alongside the company’s chief operating officer, Toth set in motion in 2012 a massive effort to identify operational inefficiencies at the company’s 200-plus locations, which served local construction markets. The work essentially was a build-out of the financial planning and analysis (FP&A) function that completely revamped the company’s internal financial reporting.

Mapping Margins

Toth’s team created what they called a “Heat Map,” a huge Excel chart set up in Toth’s office in which the rows were the operating units and the columns were financial metrics. Dozens of metrics were used, including mix of products sold and various costs as a percentage of sales, like labor, indirect expenses, materials and rent. For each of 212 locations, the metrics were color-flagged to indicate whether each was in line with the overall company average, out of line or borderline.

“We needed to regain credibility,” he says. “Our stock was trading at $2.50, and our market value was less than our debt.”

Toth expected from the outset that the results of the effort would be big. “We said to the market and the rating agencies, ‘We’re going to tell you what we’re going to do, and then we’re going to do it.’ The market kind of said, ‘We’ll believe it when we see it.’ That was fine, because we were going to deliver.”

The specific goal was to zero in on locations delivering poor gross margins and either get them to do things differently or shut them down. Gross margins of less than 25 percent contributed little or no actual profit; Toth sought a 35 percent standard.

To facilitate that, finance had monthly calls with the locations to identify action areas and teach them how to read the Heat Map.

Notes Toth, “We’d say, ‘Look at your location, you have a 22 percent margin.’ They might say, ‘The rent is high in this location.’ And we were, “No it’s not. Your rent is 9 percent of sales, and the company average is 8 percent. Your problem is labor. Your cost is 25 percent of sales, while company-wide it’s 14 percent. You’ve got to tell us why.’ We were able to get down into each location very quickly and train them how to look at their business.”

The threat of being shut down was a strong motivator for behavioral change. For Toth, the ability to deliver that message and back it up with action was important. “It was actually very liberating, taking the approach that we will shut you down. We’re going to restructure with a capital R, so you’d better take the gloves off and start looking around your territory, because you’ve got to have a 35 percent gross margin.”

ARC actually did wind up shutting down 31 locations and improving the margins of many others. The impact on the company was immediate and powerful. In the four quarters of 2013, compared to the year-earlier quarters, ARC enjoyed gross-margin improvements of 160, 210, 310 and 260 basis points.

Because of the improved operational performance, Toth was able to refinance about $200 million in debt and reduce the interest rate to 6.25 percent from 10.5 percent.

The key to that victory was accurate forecasting. “The challenge in working with rating agencies is that they, like financial institutions, tend to forecast off trends,” Toth says. “A forecast that is anti-trend is, for good reason, suspect. But a company at an inflection point is by definition bucking the trend.”

He continues, “So when I told the rating agencies in 2012 that we were going to change our trend, I was very specific about how and when. I told them, several quarters in advance, when we were going to change our revenue trend, when we were going to turn our margins around, when we were going to regain profitability. We hit those forecasts and were then able to get better credit.”

ARC’s investors are in on the fun as well. The company’s stock was trading at $7.62 early Thursday afternoon, roughly three times the measly level it was at last February. Earnings per share soared from negative four cents in 2012 to plus-nine cents in 2013. Cash flow from operations hiked from $37.5 million to $46.8 million.

Speaking the Language of Operations

According to Toth, the big run will continue this year. He’s expecting the stock price to double, and the company’s EPS guidance is in the range of 19 to 23 cents. “I talk to our investors a lot, I know how we’re valued and I know what our metrics are going to do over the next couple months,” he says.

That confidence also flows in part from a plan to expand the use of the Heat Map. Last year the company focused on improving operations in its “shop business” at locations owned or leased by the company. This year the same will be done for ARC’s “on-site” business — managing printer fleets at customer locations.

At the same time, the shop business should continue to improve its margins, Toth believes. While naturally there will be diminishing returns, with many of the most important changes already made, the locations understand their business better now, he says.

Becoming more aware of sales mix was an important learning experience for the locations. Operations people don’t necessarily think about the mix, or how much they’re selling in various product lines, says Toth. “You have to break it down for them, show them that a software sale is a 70-percent-margin sale, while a piece of equipment is a 20-percent-margin sale.”

Also, expressing metrics in different ways resonates with some operations folks. For example, instead of saying labor costs should be kept to 14 percent of sales, it might be effective to say that the cost of goods sold (COGS) should be about $5,000 per person. “That’s a metric that works for them as they actually operate the plant floor,” says Toth. “It generally reflects the same information, but they can more easily integrate the COGS metric into their thinking than the 14 percent, which is a pure corporate finance metric.”

The variability in the locations’ gross-margin results illustrates why troubled companies should avoid making so-called “peanut butter” cuts, spreading, say, a 10-percent headcount reduction evenly across company units. “If you treat everyone the same, you inflect damage on the healthy tissue as well as the unhealthy,” he notes. In ARC’s case, some locations had gross margins as high as 50 percent, while more than two dozen others were south of 20 percent.

Toth, summing up the cultural shift the company has gone through, says, “We were able to evolve our management reporting to be very valuable, precise, granular and substantive. We put that reporting in terms the operators could understand and act on.”

It should be a lesson for other finance executives, he stresses. “Next time a CFO gets pushback on improved reporting, he or she should point to what we’ve been able to do,” Toth says.